(As published in LifeStyles 55+ August 2012)
Risk is a fact of life. We risk a fall when we get out of bed, and take our life in our hands every time we cross a street, compounding that risk if we J-walk! Our challenge for a continuing long and healthy life is to manage the risks we face each day. This can be as simple as reducing risky behaviour, like avoiding J-walking, looking both ways and using controlled crossings to reduce the risk of getting run over.
The most common risk management strategy is avoidance. We could stay home and avoid the risk associated with crossing the street altogether. But the price would be that we forego the enjoyment of getting out, shopping and socializing. That would be too high a price for most of us so we manage the risk. First, by reducing the chance of a bad event occurring and then by preparing to mitigate the effects should it do so.
Proactive risk management begins with identifying the risks we face. We know our house could catch fire. We can reduce the risk of that happening by making sure the wiring is up to date and in good condition, and by eliminating or reducing possible sources of ignition through measures like lightening protection. Despite our best risk reduction management, though, something might go wrong. Then risk mitigation kicks in. We install smoke detectors and even monitored alarm systems so that a fire occurrence can be detected early and action taken. We carry insurance to provide for the repair of any damage: insurance is a key part of risk management.
We need to apply the same approaches in managing our money. Managing financial risk is especially challenging in today’s investment environment where traditional approaches are being turned on their heads: the money supply has been expanded to create more jobs; the bank rate has been held at historic lows. The government’s compression of interest rates means that “safe” investments like government bonds may pay less than the rate of inflation, leaving you with a negative return in real terms.
A simple example of risk management at the financial level is putting your money in GICs, where your principle is “guaranteed” by your bank. Most GICs are paying an amount that is lower than the rate of inflation, so that the GIC costs you money in real terms. Is this an acceptable strategy for managing your wealth? Notif you are no longer working (for a pay cheque) and your money needs to be working for you.
So if leaving your money in GICs is equivalent to staying home, and going out to live life means investing at least some of your portfolio in equities, how can you manage the risk brought on by swings in the business cycle? Professional portfolio managers use risk mitigation techniques such as diversification. They also buy and sell derivatives, though admittedly this is a scary word today for many investors.
But there is another avenue that can be attractive. You can insure your principal. That’s right, just like you buy insurance on your home, you can insure your investment portfolio. All major insurance companies sell segregated funds, a name that simply means these funds are “segregated” from the insurance company’s own funds that underwrite their insurance obligations.
A seg fund can be almost any mix of investments. Seg funds have not been well understood by retail investors because they generally carry a higher management expense ratio (MER), the fee deducted for managing the investor’s money. But the difference is usually less than 0.5 per cent. This is the premium you pay for insuring your capital. Your principal is guaranteed for both the contract maturity date (like a GIC) and for death. As an insurance contract it has tax-preferential treatmentt and goes directly to the beneficiary without the delays of probate that other investments such as mutual fund assets would go through.
Insuring the principal of your assets in a seg fund may allow you to tolerate a higher degree of volatility risk in your portfolio. For example, say you choose a fund of dividend-paying blue chip equities and corporate bonds. You might expect a return over 10 years to average eight per cent, from which you net six per cent after the two per cent MER (which has included the “insurance” for the principal guarantees). Over your planning horizon, you should do better by 3.5 percentage points than if you had your money in a 10-year GIC at 2.5 per cent.
While this extra return is not guaranteed, most seg funds allow you to “reset” your maturity and death benefit guarantees. So when the market finally shows some recovery, you could reset your guarantee to lock in the growth. Then, even if there is a future downturn, your capital plus the growth from your reset will be guaranteed.
Seg funds also allow you to change your portfolio mix by shifting money between funds of the insurance company. Finally, should you wish to draw some income from your seg fund, another option is to use it, with its death benefit guarantee, as collateral for tax-free annual loans which could be in equal amounts no matter what is happening in the markets that year.
If you really need higher returns to insure your future, there are tools to manage the volatility risks – you can buy derivatives, or you can insure your money in a seg fund investment. Exactly how you can best use seg funds, with insured principal guarantees, while expecting higher returns, will require a detailed review with your financial advisor. But before you next renew a GIC, ask about investing in a seg fund.